CLIENT NOTE ALERT! REPO HAS FINALLY MADE UP ITS MIND AND IS ON ITS WAY TO THE CIVIL CODE - TK & Partners
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
TK & Partners February 21, 2020
CLIENT NOTE
ALERT! REPO HAS FINALLY MADE UP ITS MIND AND IS ON
ITS WAY TO THE CIVIL CODE
OVERVIEW
On 23 January, a Law on Amendments to the Civil Code1
passed first reading at the Parliament, under which it is
intended to add a paragraph on repo transactions to the
Civil Code.
REPO AND REVERSE REPO
A repurchase agreement (or repo) is a sale of securities
or other financial instruments and subsequent buyback
thereof (or other instruments equivalent2 to those)
within a certain period of time - usually the following
day.3 During this time to maturity, the buyer holds a
legal title to the collateral and is entitled to benefits,
including coupons, dividends or other income paid by the issuer. Provisions on making marginal
payments are also inherent to repo agreements.
1
See the Draft Law at http://parliament.am/drafts.php?sel=showdraft&DraftID=55697
2
Pursuant to GMRA, “equivalent” means assets that are economically, but not necessarily legally identical (the same issue
of securities with the same ISIN or, if the issue is divided into classes or tranches, the same class or tranche, but not the
same part of that issue, class or tranche).
3
Such repos are frequently referred to as overnight repos.
TK & Partners Client Note 1
TK & Partners February 21, 2020
Every repo is simultaneously a reverse repo. In particular, while the seller enters into repo, the buyer
enters into reverse repo. Thus, a reverse repo is a purchase of securities that are sold back on
termination.4
ESSENCE OF REPO TRANSACTIONS AND
THEIR ROLE IN FINANCIAL MARKETS
Essentially, a repo is a particular type of short-
term borrowing. From the point of view of
motivation of parties entering into a repo
agreement, the essence of such transactions
comprises secured loan of cash. Although an
asset is sold outright at the start of a repo, the
commitment of the seller to buy back the asset in
the future means that the buyer only has
temporary use of that asset, while the seller only
has temporary use of the cash proceeds of the
initial sale. The interest on this loan is the
payment made in the repo.
However, legally, a repo is a sale and purchase transaction. The feasibility of employing this legal form
lays in necessity to protect the cash lender (buyer). As under a repo transaction the buyer becomes
the owner of the collateral and holds full legal title thereof, in case of insolvency or default of the
seller (borrower), the buyer will be in possession of the security and will not be obliged to wait in the
queue of creditors of the defaulting party under uncertainty whether the means of the latter will
suffice for satisfaction of his claim. Thus, for ensuring necessary terms of validity, enforceability,
priority or parties’ interests and those of third persons, a repo agreement has to be characterized as
a sale and purchase agreement, notwithstanding economic motivations thereof.5
Repo markets have vital links with bond, equity and derivatives markets. They are widely used for
hedging primary debt issuance, supporting corporate bond investors, hedging and pricing derivatives,
etc.
Moreover, repos are used by market-makers for the purpose of ensuring liquidity of securities and
derivatives, as well as are key instruments in the implementation of monetary policy by central banks
of many countries. By being able to offer deposits secured by a legal title to high-quality liquid assets
and diversification to include lenders other than commercial banks, repo is able to mobilize cheaper
and deeper funding for financial intermediaries, in particular, securities dealers, and eventually to
4
Moorad Choudhry, The REPO Handbook, Second Edition (Securities Institute Global Capital Markets), page 118.
5
However, due to shortcomings in regulation in many jurisdictions there is still a risk that repo s treated as a secured loan
and not an outright sale (recharacterization risk).
TK & Partners Client Note 2
TK & Partners February 21, 2020
create a more resilient market. As a monetary policy instrument, a repo enables central banks to
implement monetary policy more efficiently under normal market conditions and to act more swiftly
as lenders of last resort during periods of market stress.6
GMRA
Since repo transactions are widespread and
popular on international financial markets, states
and other public entities, as well as standard
setting organizations have been trying to
standardize the legal framework of repo
transactions in order to avoid conflicts of legal
treatments across jurisdiction. In November
1992,7 the International Securities Market
Association (ISMA)8 introduced the Global
Master Repurchase Agreement (GMRA), which is
the market standard repo document used as the
legal basis for repo in non-US dollar markets9 and
is widely used on the international market for both cross-border and domestic repos.
The GMRA is designed for short-term repos of simple high-quality fixed-income securities that take
the form of repurchase transactions between principals under the law of England and Wales (Annex
1). To adapt the master agreement to jurisdictions other than England and Wales, there are also a
number of country annexes. Moreover, parties intending to enter into a repo transaction are free to
add additional terms and provisions to those reflected in Annex 1.
GMRA defines main features of repo agreements. Pursuant to it, repo agreements should be
structured as outright sale and purchase transactions, and full title of ownership shall be transferred
to the buyer of the security. Legal title to collateral shall be confirmed in event of default. Repo
agreements should mandatorily provide for the obligation of the buyer to return the security or
equivalent asset. Initial and variation margin should be covered by the agreement, and, finally, a
coupon should be paid over to the seller at the time of payment.
To ensure effectiveness and actuality of the provisions of the GMRA, the ICMA commissions annual
legal opinions on behalf of its members (over 500 authoritative financial institutions) as to the
6
See commentary by ICMA at https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-
markets/icma-ercc-publications/frequently-asked-questions-on-repo/3-what-is-the-role-of-repo-in-the-financial-markets/.
7
The GMRA was later updated in 1995 to incorporate lessons learned in the Baring Brothers crisis, in 2000, to incorporate
lessons from the Russian and Asian financial crises, and in 2011, to harmonize the GMRA more closely with other master
agreements, including the Global Master Securities Lending Agreement (GMSLA) and the ISDA Master Agreement.
8
Renamed the International Capital Markets Association (ICMA) in October 2005.
9
Moorad Choudhry, The REPO Handbook, Second Edition (Securities Institute Global Capital Markets), page 343.
TK & Partners Client Note 3
TK & Partners February 21, 2020 applicability and effectiveness of the GMRA in over 65 jurisdictions. Those legal opinions address repo transactions with banks, investment companies, as well as other financial institutions. CURRENT ARMENIAN LEGISLATION Currently, Armenia’s primary legislation does not regulate repos, which means that there is no legislative act which would define a repo as a specific type of transaction and stipulate main features and requisites thereof. The only regulation on repos under Armenian legislation is that which is enshrined in a number of secondary legal acts of the Central Bank on monetary policy instruments. In particular, Decision 246-A of the Board of the CBA on Approval of Document on Indirect Instruments of the Monetary Policy of the Central Bank and the Mechanisms of Application thereto defines repos as transactions whereby the commercial bank will sell securities to the Central Bank at an agreed price with an obligation to repurchase them upon the day of maturity and pay the relevant interest amount, while the Central Bank will obtain the securities with an obligation to resell them upon the day of maturity. Further, a reverse repo was defined as a transaction whereby the commercial bank will obtain securities from the Central Bank at an agreed price with an obligation to resell them upon the day of maturity, while the Central Bank will sell securities with an obligation to repurchase them and pay the relevant interest amount upon the day of maturity. The mentioned Decision, as well as Decision 20-A of the Board of the CBA on Approval of the Rules of Repo/Reverse Repo System of the Central Bank define the procedure of concluding repo and reverse repo transactions as monetary policy instruments. Thus, currently, repos are only addressed in legal acts of the Central Bank exclusively in capacity of monetary policy instruments. As to primary legislation, no law of the Republic of Armenia addresses repos as specific types of transaction. PENDING AMENDMENTS TO THE CIVIL CODE The Draft Law on Amendments to the Civil Code, which was drafted by the Government of Armenia (with the support of the Central Bank) and already passed first reading in the Parliament, aims at adding a separate paragraph entitled “Repurchase Agreement” to the Civil Code. The paragraph is to be added to Chapter 31 regulating sale and purchase transactions, which means that the legislator identifies a repo as sale and purchase transaction. Moreover, it is stipulated in the Draft Law, that general provisions on sale and purchase transactions enshrined in Chapter 31 of the Civil Code shall apply to repurchase agreements, unless otherwise provided by the repurchase agreement or application of those provisions contradicts the essence of the repo. TK & Partners Client Note 4
TK & Partners February 21, 2020
The definition of repo in the Draft Law is the following: on the basis of a repurchase agreement one of
the parties - the seller, shall be obliged to transfer to the other party – the buyer, by way of right of
ownership, securities, and the buyer shall be obliged to accept those securities and pay for them the
specific amount of money established by the agreement, and subsequently, within the term stipulated
by the Agreement, to sell back to the Seller securities equivalent to those purchased, and the seller
shall be obliged to accept those securities and pay for them the specific amount of money established
by the agreement.
The Draft Law defines equivalent securities as well. In particular, within the meaning of the
amendments, securities shall be considered as equivalent in case of being issued by the same issuer
and within the same issuance, having the same type, nominal value and characteristics and being of
same quantity or volume, unless otherwise stipulated by the Agreement.10
The Draft Law provides for possibility to envisage obligations to make marginal payments (including
accruing interest of them) and to transfer to the seller an amount of money equivalent to the income
paid on securities by the issuer (coupon payments, bond redemptions, etc.).11
In the case a security is sold under a repo or transferred as a margin transfer is redeemed before its
equivalent is repaid as provided by the repo, the redemption amounts are repaid instead of the
equivalent security, unless otherwise provided by the repo.
Finally, repurchase agreements shall be done in writing12 and shall in no way be considered as
derivative financial instruments.
MAIN BENEFITS OF THE DRAFT LAW AND CONCERNS ASSOCIATED THEREWITH
The main rationale behind initiation of the legislative amendments at issue is the Central Bank’s desire
to primarily avoid uncertainty as to the treatment of repo transactions from legal perspective and to
finally reach the publication on ICMA’s website of a country’s legal opinion on the enforceability of
the GMRA in the Republic of Armenia,13 which will improve positions of the Republic of Armenia on
the international repo market and attract foreign investors to enter into the local repo market.14 For
10
This definition reflects the one enshrined in GMRA.
11
The Draft Law provides explicitly that these payments shall not be considered as gifts.
12
Non-compliance with the requirement of written form shall result in invalidity of the Repo Agreement.
13
See the justification of the Draft Law by the Central Bank at
http://parliament.am/drafts.php?sel=showdraft&DraftID=11158&Reading=0.
14
The main criterion the ICMA bases its legal opinion on is the applicability of the GMRA in a certain jurisdiction on is
lawfulness of the transaction under domestic law. This is of particular importance, because in case of not being regulated
explicitly under domestic law there is a big risk that courts may recharacterize repo transactions, hold them being sham,
invalid, etc. Note, that a number of other risks that traditionally are considered in the context of repo transactions were
TK & Partners Client Note 5
TK & Partners February 21, 2020
example, in order to conclude repurchase agreements with Armenian banks, members of the ICMA
shall not be obliged to ask the ICMA for a distinct legal opinion, which will result in additional costs for
those members of the ICMA.
For the purpose of ensuring availability of the ICMA’s legal opinion on applicability of the GMRA in
Armenia, the mentioned amendments are of essential importance since the main criterion the ICMA
bases its legal opinion on the applicability of the GMRA in a certain jurisdiction on is lawfulness of the
transaction under domestic law, because in case of not being regulated explicitly under internal law,
there is a big risk that courts may recharacterize repo transactions, hold them being sham, invalid, etc.
From this perspective, especially to avoid recharacterization, it is very important that the provisions
on repo will find their place in the Civil Code, in other words – will fall under legal definition of sale
and purchase.
At the same time, it is worth mentioning that a number of provisions referred to above differ from the
provisions of the GMRA. For example, the Draft Law limits the scope of repo collateral exclusively to
securities, while under the GMRA’s other financial instruments (e. g. derivatives, bank loans, bank
gold, etc.) may also be traded under a repo transaction. However, it is necessary to stress that the
initial version of the Draft Law stipulated that financial instruments – securities, money market
instruments, financial derivative instruments certifying rights to obtain securities, bank gold and rights
with regard credits could be traded under repo.15
Furthermore, while under the GMRA, in case of availability of an initial written agreement (main
agreement) between parties, repurchase agreements may be entered into orally, and the initial draft
too provided for such possibility.16 On the contrary, under the Draft Law, repurchase agreements may
be entered into in writing exclusively. Moreover, non-compliance with that requirement shall end in
invalidity of the agreement.
As a conclusion, while the main rationale behind initiation of legal regulation on repos is achieving
publication of legal opinion by the ICMA on the applicability of the GMRA in Armenia, some draft
provisions considerably narrow the scope of repos as compared to the scope thereof under the GMRA.
HOW CAN WE HELP?
already addressed in the context of derivatives reform that the GoA has completed in 2016 as a result of which ISDA
country opinion has been published in 2019. See more: http://tk.partners/en/evolving/isda/
15
See the initial draft at https://www.e-draft.am/en/projects/1491/about.
16
The initial draft also provided that the written agreement could envisage that in such cases oral communication would be
recorded in order to be used as evidence of terms and conditions of the transaction. See the initial draft at https://www.e-
draft.am/en/projects/1491/about.
TK & Partners Client Note 6TK & Partners February 21, 2020
Our lawyers have deep knowledge of financial law and extensive experience in drafting complex
financial transactions. Hiring us for legal advice on those matters will definitely mean ensuring the
best protection of your interests.
NOTE: This material is for general information only and is not intended to provide legal advice
Alexandr Khachaturyan, Partner Larisa Gevorgyan, Junior Associate
akhachaturyan@tk.partners lgevorgyan@tk.partners
TK & Partners Client Note 7You can also read
